By David A. Hershey
Frank Sortino feels vindicated now that "the Nasdaq is up more than 70% from its low. Hello!" ("Stocks, and bonds, still best for the long run" Other Views, Feb. 9). Commenting on his piece, however, highlights the weaknesses inherent in the efficient frontier investment approach and helps clarify the reasonableness and the benefits of adopting a liability benchmark for pension investing.
1) Mr. Sortino wishes to make liability values an artificial construct of the accountants and actuaries. However, the obligations exist not as a result of man-made laws but in the nature of the sponsor's promise.
A plan's obligations closely resemble a bond that can be valued using market discount rates. In a liability benchmark framework, an immunized bond portfolio can be considered the risk-free asset because it largely eliminates the primary source of liability risk: return swings which result from changes in interest rates.
2) As Mr. Sortino writes, "… risk management or risk budgeting. These are catchy phrases that appeal to the emotions of an investment community that is still suffering from the trauma of the worst bear market it has ever witnessed." Actually, the bear market brought to light the serious mismatch risk pension investors blithely ignored. How many plans, when they expressed discomfort with the elevated equity market levels of the late '90s, were made aware that bond investments were the risk-free alternative?
3) We should be suspicious of an investment theory that does not recognize the validity of using an immunized bond portfolio when market conditions warrant. Investors implementing an immunized bond strategy, such as Boots PLC started in 2000, locked in substantial surpluses and avoided the shortfalls that stunned the rest of the industry. Does Mr. Sortino seriously contend that an efficient frontier portfolio is always the right asset mix?
Ignoring the market value of pension liabilities will not make them go away; they reside in the retirement promise. This is not to say you should always be 100% immunized, but only to say that when you accept the added risk that comes from straying from the benchmark, you should have a reasonable basis for expecting a reward.
4) But Mr. Sortino says, "If you are not diversifying across asset categories, you not investing — you are speculating." This ignores the reality of a liability benchmark. A portfolio of immunized bond investments significantly reduces benchmark risk. Yet, Mr. Sortino claims that "putting all of your money in one asset category constitutes a breach of fiduciary responsibility." Is it credible to maintain that securing the employee's retirement income is a breach of fiduciary responsibility?
5) Nowhere is Mr. Sortino's misunderstanding of the meaning and usefulness of a liability benchmark more evident than when he declares, "No one would argue in favor of 401(k) participants putting all their money in bonds instead of a well-diversified portfolio because 401(k) plans don't have accountants and actuaries arbitrarily picking an interest rate that discounts the future benefit payments to the present value."
But the ultimate goal of a DC investor is the same as a DB investor: to provide a retirement income to the investor. The liabilities are the cash flows out of the portfolio that the investor will require in retirement. They are based on employee's desired income level. The use of bond investments to defease that obligation is not a breach of fiduciary duty, as Mr. Sortino claims, but a near guarantee that the employee will receive the necessary income payments. Both DC and DB investors share the same strategic alternatives: to either match a liability benchmark through bond investments, or to try to beat it by taking various kinds of risk in asset classes other than bonds.
6) Mr. Sortino asserts that generating returns above an arbitrarily chosen minimum acceptable return would reduce a firm's cost of capital, while realizing returns below the MAR would raise its cost of capital. This is contrary to the invariance principle established by Merton Miller and Franco Modigliani in their seminal paper written in 1958. The cost of making a pension promise is set by the terms of the promise, without regard to the composition of the asset mix used to fund the promise.
7) In his 2003 book "Benchmarks and Investment Management," Laurence Siegel compares the post-crash attacks to modern portfolio theory, like behavioral finance and absolute return benchmarks (which would include Mr. Sortino's MAR benchmark). He concludes, "A focus on liabilities, not on absolute return benchmarks, is the key contribution being made by those who are skeptical of the traditional approach to benchmarking." The industry would do well to note the results directly attributable to Mr. Sortino's approach and to heed Mr. Siegel's words.
David A. Hershey is senior portfolio manager at Lotsoff Capital Management, Chicago.
